What is a Debenture in Accounting? Types, Features & Examples

A debenture is a long-term financial instrument that companies or governments use to borrow money at a fixed interest rate without pledging any collateral. For example, if a company issues a ₹10 crore debenture for 10 years at 8% interest, investors receive regular interest income while the company secures long-term funds.

In this blog, let’s walk through the full concept of debentures, their types, characteristics, and real-world application, through the story of Priya, a new investor exploring different investment options.

What is a Debenture?

A debenture is a long-term loan instrument issued by a firm or the government to raise funds from investors. By purchasing a debenture, an investor effectively lends money to the issuer in exchange for periodic interest payments and the return of the principal amount at a specified maturity date.

Key Characteristics:
 

• Interest Payments: The issuer pays a fixed interest rate (known as a coupon) at regular periods.
   
• Maturity Date: The debenture has a specified tenure after which the principal amount is repaid to the investor.
   
• Tradability: They are tradable on the bond/debt market, allowing investors to sell them before maturity.
   
• Security: It is crucial to note that debentures are typically unsecured. This means they are not backed by specific physical assets or collateral. Instead, they are backed only by the general creditworthiness and reputation of the issuer. Secured versions do exist but are less common and must be explicitly stated as such.
   

Example: Priya invests ₹1,00,000 in an unsecured debenture from ABC Ltd., which offers a 9% annual coupon and a 5-year maturity. Let’s see how much she will receive: 
 

As shown, debentures can provide a predictable and steady stream of income, making them attractive for conservative investors.

Types of Debentures

Debentures can be classified in multiple ways depending on their characteristics:
 

1. Based on security:
    

• Secured Debentures use specific firm assets as collateral. In the event of default, debenture holders may seek repayment from the sale of such assets.
   
• Unsecured debentures, also known as naked debentures, are not collateralised and are purely based on the issuing company's credibility and reputation.
   

2. Based on convertibility:
    

• Convertible Debentures can be converted into equity shares after a set length of time, providing investors with the opportunity for financial appreciation if the firm performs well.
   
• Non-convertible Debentures (NCDs) cannot be converted into shares and only provide fixed interest income over time.
   

3. Based on redemption:
    

• Redeemable Debentures have a predetermined maturity date by which the issuing business must refund the principal amount to investors, thereby terminating the debt obligation.
   
• Irredeemable (Perpetual) Debentures have no fixed repayment date and remain active until the corporation decides to redeem them, usually at a higher interest rate to compensate for the indefinite length.

Example: Priya, a careful investor, selected a secured, non-convertible, redeemable debenture from XYZ Ltd. for ₹1,00,000 with a 7-year term and 8.5% annual interest, providing safety, set yields, and capital recovery.

Types of Debentures at a Glance

The table below provides a summary of the various ways debentures can be classified.  This allows them to compare and contrast their essential characteristics at a glance.
 

Understanding these categories is essential for selecting the right debenture that matches your investment goals and risk appetite.

Features of Debentures

Understanding the key features helps investors evaluate the risk-return trade-off:
 

• Fixed Income: Offers predictable returns
   
• No Ownership Dilution: Debenture holders are creditors, not owners
   
• Market Tradability: Can be traded on stock exchanges
   
• Credit Rating: Rated by agencies (CRISIL, ICRA) to indicate risk
   
• Tenure: Can range from 1 to 20 years, depending on the issuer
   

Example: A ₹50,000 NCD by DEF Ltd. was rated AA+, offered 10% interest for 3 years, and was tradable on BSE.

This table summarises the key features of a real-world debenture issue. It shows how abstract features translate into a concrete investment opportunity.
 

A high credit rating and exchange listing, as shown here, significantly enhance the safety and liquidity of a debenture.

Accounting Treatment of Debentures

In accounting, debentures are regarded as long-term liabilities because they represent borrowed capital. When a corporation issues debentures, it gets cash from investors and records the transaction as 'Debentures A/c' in the balance sheet's liability column.
 

• At the time of issuance, the corporation records a journal entry that debits the Bank Account and credits the Debentures Account, indicating the obligation to repay the principal later.
   
• Interest payments: Debenture interest is a business expense. It is documented by debiting the Interest Account and crediting the Bank Account when paid. This sum is also shown on the profit and loss statement, decreasing taxable income.
   
• At redemption: When debentures mature, they are redeemed for the principal amount. The journal entry debits the Debentures Account while crediting the Bank Account, reducing the company's liabilities.
   

Example: If a company issues ₹5 crore worth of debentures at 9% interest:
 

• Every year, ₹45,00,000 is recorded as interest expense
   
• The balance sheet reflects ₹5 crore under liabilities
   

Accounting Impact of Debenture Issue
 

Advantages and Disadvantages
 

Advantages for Investors:
 

• Regular income with less risk than equity
   
• Priority over equity in case of bankruptcy
   
• Rated by agencies for transparency
   

Advantages for Companies:
 

• Access to long-term capital
   
• No dilution of ownership
   
• Tax benefits on interest paid
   

Disadvantages:
 

• Fixed obligation, even if the company makes a loss
   
• Higher interest rate for unsecured debentures
   
• Price volatility in the secondary market
   

Example: If a company defaults, equity investors may lose everything, but secured debenture holders can recover value from pledged assets.

Pros and Cons of Debentures

This table contrasts the key benefits and drawbacks for the main parties involved in a debenture agreement.
 

Weighing these pros and cons is a critical step before either issuing or investing in debentures.

Conclusion

Debentures are a powerful tool in accounting and finance, offering benefits for both companies and investors. Whether you're a conservative investor seeking regular income or a business looking for capital, understanding the types and features of debentures is essential.

As Priya learned, with a bit of research and understanding of terms like coupon rate, credit rating, and tenure, one can make informed choices and build a balanced investment portfolio.

FAQs

What happens if a corporation fails to make its payments?

A default enables the debenture trustee to take action. They may confiscate secured assets or pursue legal action to collect payments for investors.

How is the debenture interest rate determined?

The rate is determined by the issuer depending on the credit rating and market conditions.  Riskier enterprises must provide higher rates in order to attract investors.

Can a firm repay debentures early?

Yes, if they are callable debentures. The corporation may provide a premium to investors for early redemption.

Are debenture interest payments taxable to investors?

Yes, interest income is fully taxable as "Income from Other Sources."  It is added to the investor's overall income for the year.

 

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About the Author

LoansJagat Team

‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.